The unaudited consolidated financial statements include the accounts of Summit Financial Corporation (the “Company”), a South Carolina corporation, and its wholly-owned subsidiaries, Summit National Bank (the “Bank”), a nationally chartered bank, and Freedom Finance, Inc. (the “Finance Company”), a consumer finance company. Also included are the accounts of Summit Investment Services, Inc. (the “Investment Company”) which is a wholly-owned subsidiary of the Bank. All significant intercompany items related to the consolidated subsidiaries have been eliminated.
Through its bank subsidiary, which commenced operations in July 1990, the Company provides a full range of banking services, including the taking of demand and time deposits and the making of commercial and consumer loans. The Bank currently has four full service branch locations in Greenville and Spartanburg, South Carolina. In 1997, the Bank incorporated the Investment Company as a wholly-owned subsidiary to offer nondeposit products and financial management services. The Finance Company commenced operations in November 1994 and makes and services small installment loans to individuals from its eleven offices throughout South Carolina.
The significant accounting policies followed by the Company for interim reporting are consistent with the accounting policies followed for annual financial reporting. The unaudited consolidated financial statements of the Company at September 30, 2004 and for the three month and nine month periods ended September 30, 2004 and 2003 were prepared in accordance with the instructions for Form 10-Q. In the opinion of management, all adjustments (consisting only of items of a normal recurring nature) necessary for a fair presentation of the financial position at September 30, 2004, and the results of operations and cash flows for the periods ended September 30, 2004 and 2003 have been included. The information contained in the footnotes included in the Company's latest annual report on Form 10-K for the year ended December 31, 2003 should be referred to in connection with the reading of these unaudited interim consolidated financial statements. Certain interim 2003 amounts have been reclassified to conform with the statement presentations for the interim 2004 period and to reflect the effect of the 5% stock dividend paid in December 2003.
The results for the three month and nine month period ended September 30, 2004 are not necessarily indicative of the results that may be expected for the full year or any other interim period.
For the purposes of reporting cash flows, cash includes currency and coin, cash items in process of collection and due from banks. Included in cash and cash equivalents are federal funds sold and overnight investments. The Company considers the amounts included in the balance sheet line items, “Cash and due from banks”, “Interest-bearing bank balances” and “Federal funds sold” to be cash and cash equivalents. These accounts totaled $18,396,000 and $11,573,000 at September 30, 2004 and 2003, respectively.
Management maintains a list of potential problem loans which includes non-accrual loans, loans past due in excess of 90 days which are still accruing interest, and other loans which are credit graded (either graded internally, by independent review or regulatory examinations) as “watch”, “OAEM”, “substandard”, “doubtful”, or “loss”. A loan is added to the list when management becomes aware of information about possible credit problems of borrowers that causes doubts as to the ability of such borrowers to comply with the current loan repayment terms. The total amount of adversely classified loans (i.e., defined as loans with a credit grade of “substandard”, “doubtful”, or “loss”) at September 30, 2004 was $5.5 million or 2.5% of the loan portfolio at September 30, 2004, compared to $3.5 million or 1.5% of the loan portfolio at December 31, 2003, and $4.6 million or 2.1% of the loan portfolio at September 30, 2003. The amount of potential problem loans at September 30, 2004 does not represent management’s estimate of potential losses since the majority of such loans are considered adequately secured by real estate or other collateral. Although adversely classified loans have increased somewhat during the nine months ended September 30, 2004, loans classified as OAEM have decreased substantially by $6.9 million since December 31, 2003. The overall decrease in the amount of total classified loans in 2004 is primarily related to the significant payoffs and paydowns in loans and management proactively worked these loans to improve the quality of the portfolio, as well as an improvement in the general economic conditions during the period. Management believes that the allowance for loan losses as of September 30, 2004 is adequate to absorb any losses related to the nonperforming loans and potential problem loans as of that date. Management continues to monitor closely the levels of nonperforming and potential problem loans, and will address the weaknesses in these credits to enhance the amount of ultimate collection or recovery on these assets. Should increases in the overall level of nonperforming and potential problem loans accelerate from the current trend, management will adjust the methodology for determining the allowance for loan losses and will increase the provision for loan losses accordingly. This would likely decrease net income.
EARNINGS REVIEW - COMPARISON OF THE THREE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
GENERAL
The Company reported consolidated net income for the three months ended September 30, 2004 of $1,148,000, compared to net income of $970,000 for the three months ended September 30, 2003, or an improvement of approximately $178,000 or 18%. The primary contributors to increased earnings for the third quarter of 2004 was the lower cost of funds, lower provision for loan losses and control of overhead expenses. The reduction in the provision for loan losses was related to the lower originations in 2004 as compared to the prior year and the overall improvement of credit quality in the loan portfolio. The improvements in income were somewhat offset by the 28% reduction in other income primarily as a result of lower mortgage referral fees.
NET INTEREST INCOME
Net interest income, the difference between the interest earned and interest paid, is the largest component of the Company’s earnings and changes in it have the greatest impact on net income. Variations in the volume and mix of assets and liabilities and their relative sensitivity to interest rate movements determine changes in net interest income. During the quarters ended September 30, 2004 and September 30, 2003, the Company recorded net interest income of $3.2 million and $3.1 million, respectively. The 22 basis point increase in net interest margin was somewhat offset by the 2% decrease in average earning assets between the two periods, thus resulting in the $109,000 (4%) increase in net interest income between the third quarter of 2003 and the third quarter of 2 004.
For the three months ended September 30, 2004 and September 30, 2003, the Company’s net interest margin was 4.35% and 4.13%, respectively. The net interest margin is calculated as annualized net interest income divided by year-to-date average earning assets. The increase in net interest margin is related primarily to the 41 basis point increase in the prime interest rate contributing to a higher average yield on assets, combined with the 10 basis point reduction in the average cost of funds.
INTEREST INCOME
For the three months ended September 30, 2004, the Company’s earning assets averaged $301.8 million and had an average yield of 5.80%. This compares to average earning assets of $306.5 million for the third quarter of 2003, yielding approximately 5.69%. Thus, the 11 basis point increase in average yield, offset by the 2% decrease in volume of average earning assets, accounts for the nominal $2,000 increase in interest income.
Gross loans comprised approximately 75% of the Company’s average earning assets for the third quarter of 2004 and compared to 73% for the third quarter of 2003. The majority of the Company’s loans are tied to the prime rate (over 70% of the Bank’s loan portfolio is at floating rates at September 30, 2004), which averaged 4.41% and 4.00% for the quarters ended September 30, 2004 and 2003, respectively. During the third quarter of 2004, loans averaged $225.1 million, yielding an average of 6.21%, compared to $223.0 million, yielding an average of 6.13% for the third quarter of 2003. The 8 basis point increase in the average yield on loans is directly related to the increases in the short-term market interest rates and the prime lending rate between 2003 and 20 04. The 1% increase in average loans was combined with the higher average yields and resulted in the increase in interest income on loans of $70,000 or 2%.
Investment securities averaged $65.2 million or 22% of average earning assets and yielded 5.08% (tax equivalent basis) during the third quarter of 2004, compared to average securities of $77.0 million yielding 4.71% (tax equivalent basis) for the three months ended September 30, 2003. The 37 basis point increase in the average yield of the investment portfolio is related to the general increase in treasury market interest rates during 2004, sales of lower yielding investments during the period, the overall portfolio mix, and the slow down in mortgage-backed securities principal payments. As of September 30, 2004, the portfolio had a weighted average life of approximately 7.4 years and an average duration of 5.9 years. This is compared to a weighted average life of 7.7 year s and an average duration of 6.0 years as of December 31, 2003. The 15% decrease in average securities, offset somewhat by the increase in yield, resulted in the net decrease of interest income on taxable and nontaxable investments of $87,000 or 11%.
INTEREST EXPENSE
The Company’s interest expense for the three months ended September 30, 2004 was $1.1 million. The decrease in interest expense of $107,000, or 9%, from the comparable quarter in 2003 of $1.2 million was related primarily to the 10 basis point decrease in the average rate on liabilities, combined with the 4% decrease in the level of average interest-bearing liabilities. Interest-bearing liabilities averaged $244.0 million for the third quarter of 2004 with an average rate of 1.79%. This is compared to average interest-bearing liabilities of $253.6 million with an average rate of 1.89% for the quarter ended September 30, 2003. The decrease in average rate on liabilities is directly related to the maturities of fixed rate deposits and other borrowings which were renewed at lower current market rates.
PROVISION FOR LOAN LOSSES
The provision for loan losses was $33,000 for the third quarter of 2004, compared to $100,000 for the comparable period of 2003. As discussed further under the “Allowance for Loan Losses” section above, in addition to the level of net originations, other factors influencing the amount charged to the provision each period include (1) trends in and the total amount of past due, nonperforming, and classified loans; (2) trends in and the total amount of net chargeoffs, (3) concentrations of credit risk in the loan portfolio, and (4) local and national economic conditions and anticipated trends. Thus, the $67,000 or 67% decrease in the provision for loan losses is related to the lower level of net loan originations in the third quarter of 2004 as compared to the third quarter of 2003, as well as the overall improvement in credit quality of the loan portfolio as evidenced by the reduction in net charge-offs, past due loans, and classified loans. Estimates charged to the provision for loan losses are based on management’s judgment as to the amount required to cover probable losses in the loan portfolio and are adjusted as necessary based on a calculated model quantifying the estimated required balance in the allowance.
NONINTEREST INCOME AND EXPENSES
Noninterest income, which is primarily related to service charges on customers’ deposit accounts; commissions on nondeposit investment product sales and insurance product sales; mortgage origination fees; and gains on sales of investment securities, was $548,000 for the three months ended September 30, 2004 compared to $758,000 for the third quarter of 2003, or a decrease of 28%. The decrease is related to the reduction in mortgage referral fees, which decreased $112,000 as compared to the third quarter of 2003 due to the slowdown in mortgage refinance activity. Also contributing to the lower other income was a decline of $71,000 in the revenue related to merchant credit card transactions due to the Company’s outsourcing the operations of this product in mid-2004 and thereafter, receiving a residual net revenue amount.
For the three months ended September 30, 2004 and 2003, noninterest expense was $2.0 million and $2.3 million, respectively. The most significant item included in noninterest expense is salaries, wages and benefits, which totaled $1.3 million for both the three months ended September 30, 2004 and 2003. The increase of $56,000 or 4% is primarily a result of normal annual raises and higher group insurance costs, offset somewhat by lower bonus accruals in 2004.
Occupancy and furniture, fixtures, and equipment (“FFE”) expenses increased a total of $3,000 or 1% between the third quarter of 2003 and 2004. The nominal increase was due to normal increases in expenses being offset by an adjustment in property taxes for one of the Company’s branch locations and lower depreciation due to assets which became fully depreciated in 2003. There were no significant changes in or additions to property and premises between the two quarterly periods.
Included in the line item “other expenses”, which decreased $331,000 or 47% from the comparable period of 2003, are charges for OCC assessments; property and bond insurance; ATM switch fees; professional services; merchant credit card expenses; education and seminars; advertising and public relations; and other branch and customer related expenses. The decrease is primarily related to no FHLB prepayment penalties in 2004 which amounted to $166,000 in 2003 for the early retirement of several advances. Also contributing to the expense reduction was lower advertising ($39,000) and consultant fees ($21,000) in 2004 due to changes in the promotional campaigns and other programs of the Company requiring these services;lower legal fees ($31,000) related to less loan collection costs in 2004; and reductions in merchant credit card expenses ($79,000) due to the Company’s outsourcing the operations of this product line in mid-2004 and receiving a residual net revenues amount thereafter.Fluctuations in other expense categories are primarily related to deposit related expenses and are a result of normal activity of the Company and normal changes in the volume and nature of transactions.
INCOME TAXES
For the three months ended September 30, 2004, the Company reported $505,000 in income tax expense, or an effective tax rate of 30.5%. This is compared to income tax expense of $445,000 for the same period of the prior year, or an effective tax rate of 31.4%. The slight reduction in effective tax rate is primarily related to the level of tax-free municipal securities in each period.
EARNINGS REVIEW - COMPARISON OF THE NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
GENERAL
The Company reported consolidated net income for the nine months ended September 30, 2004 of $3,255,000, compared to net income of $2,938,000 for the nine months ended September 30, 2003, or an improvement of approximately $317,000 or 11%. The primary factors in the increased earnings from the same period of the prior year were the 3% increase in average earning assets, the 13% reduction in interest expense due to lower cost of funds, and the lower provision for loan losses resulting from lower net originations during the period and the improvement in overall quality of the loan portfolio. The increases in income were somewhat offset by the 26% reduction in other income as a result of lower gains on sales of investment securities and lower mortgage referral fees.
NET INTEREST INCOME
Net interest income, the difference between the interest earned and interest paid, is the largest component of the Company's earnings and changes in it have the greatest impact on net income. Variations in the volume and mix of assets and liabilities and their relative sensitivity to interest rate movements determine changes in net interest income. During the nine months ended September 30, 2004, the Company recorded consolidated net interest income of $9.5 million, a 5% increase from the net interest income of $9.1 million for the nine months ended September 30, 2003. The increase in this amount is related to the increase in net interest margin, combined with the higher average earning asset and interest-bearing liability volume of the Company of 3% and 2%, respectively.
For the nine months ended September 30, 2004 and 2003, the Company's consolidated net interest margin was 4.21% and 4.15%, respectively. The net interest margin is calculated as annualized net interest income divided by year-to-date average earning assets. The 6 basis point increase in net interest margin is related primarily to the 31 basis point reduction in the average cost of funds, offset somewhat by the 23 basis point reduction in the average yield on assets. The average prime rate decreased 2 basis points to 4.14% for the nine months ended September 30, 2004.
INTEREST INCOME
For the nine months ended September 30, 2004, the Company's earning assets averaged $312.6 million and had an average tax-equivalent yield of 5.67%. This compares to average earning assets of $302.7 million for the first nine months of 2003, yielding 5.90%. Thus, the 3% increase in volume of average earning assets, which was more than offset by the 23 basis point decrease in average yield, accounts for the $110,000 (1%) decrease in interest income between the comparable nine month periods of 2004 and 2003.
Consolidated loans averaged approximately 74% and 73% of the Company’s average earning assets for the first nine months of 2004 and 2003, respectively. The majority of the Company’s loans are tied to the prime rate (over 70% of the Bank’s portfolio is at floating rates at September 30, 2004), which averaged 4.14% and 4.16% for the nine months ended September 30, 2004 and 2003, respectively. During the first nine months of 2004, consolidated loans averaged $231.9 million, yielding an average of 6.03%, compared to $222.4 million, yielding an average of 6.35% for the first nine months of 2003. The 32 basis point decrease in the average yield on loans is primarily related to the origination and renewal of fixed rate loans at lower current market rates, combined with the slightly lower average prime lending rate between the two periods. The 4% increase in average loans, offset by the decrease in average rate, resulted in a decrease in consolidated interest income on loans of $89,000 or 1%.
Investment securities averaged $70.6 million or 23% of average earning assets and yielded 5.02% (tax equivalent basis) during the first nine months of 2004, compared to average securities of $71.2 million yielding 4.89% (tax equivalent basis) for the nine months ended September 30, 2003. The increase in average yield on the investment portfolio is related to the changes in the treasury yield curve, the timing and volume of security maturities, calls, and sales which were reinvested in instruments with higher current market rates, changes in cash flow speeds on mortgage-backed securities, and the overall portfolio mix. The 1% decrease in volume of investment securities, offset somewhat by the increase in average rate, resulted in the net decrease in interest income on taxab le and nontaxable investments of $28,000 or 1%.
INTEREST EXPENSE
The Company's interest expense for the nine months ended September 30, 2004 was $3.4 million. The decrease of 13% from the comparable nine months in 2003 of $3.9 million was directly related to the 31 basis point decrease in the average rate on liabilities, offset somewhat by the 2% increase in the volume of average interest-bearing liabilities. Interest-bearing liabilities averaged $257.5 million for the first nine months of 2004 with an average rate of 1.77%. This is compared to average interest-bearing liabilities of $253.0 million with an average rate of 2.08% for the nine months ended September 30, 2003. The decrease in average rate on liabilities is directly related to the maturities of fixed rate deposits which were renewed at lower current market rates.
PROVISION FOR LOAN LOSSES
As previously discussed under the quarterly analysis above, the amount charged to the provision for loan losses by the Bank and the Finance Company is based on management's judgment as to the amounts required to maintain an allowance adequate to provide for probable losses inherent in the loan portfolio.
Included in the net income for the nine months ended September 30, 2004 is a provision for loan losses of $193,000 compared to a provision of $502,000 for the same period of 2003. As discussed further under the “Allowance for Loan Losses” section above, in addition to the level of net originations, other factors influencing the amount charged to the provision each period include (1) trends in and the total amount of past due, classified, nonperforming, and “watch list” loans; (2) trends in and the total amount of net chargeoffs, (3) concentrations of credit risk in the loan portfolio, and (4) local and national economic conditions and anticipated trends. Thus, the $309,000 or 61% decrease in the provision for loan losses is related to the net reduction in loans outstanding for the first nine month of 2004 of $3.1 million compared to net origination of $4.6 million for the same period of 2003. In addition, contributing to the lower provision expense for the period is the overall improvement in credit quality of the loan portfolio as evidenced by the reduction in net charge-offs, past due loans, and classified loans. Estimates charged to the provision for loan losses are based on management’s judgment as to the amount required to cover probable losses in the loan portfolio and are adjusted as necessary based on a calculated model quantifying the estimated required balance in the allowance.
NONINTEREST INCOME AND EXPENSES
Noninterest income, which is primarily related to service charges on customers’ deposit accounts; commissions on nondeposit investment product sales and insurance product sales; and mortgage origination fees, was $1.8 million for the nine months ended September 30, 2004 compared to $2.4 million for the first nine months of 2003, or a decrease of $607,000 or 26%. The decrease is related to lower gains on sales of securities, which decreased $301,000 due to a reduction in the volume of sales transactions and the general market conditions effecting the amount of gain or loss on securities sold. Also contributing to the reduction in other income was lower mortgage referral fees which decreased $225,000 as compared to the first nine months of 2003 due to the significant sl owdown in mortgage refinancing activity. Finally, other income declined of $84,000 between the two periods related to merchant credit card transactions due to the Company’s outsourcing the operations of this product in mid-2004 and thereafter, receiving a residual net revenue amount.
For the nine months ended September 30, 2004, total noninterest expenses were $6.4 million, which is a decrease of $295,000, or 4%, from the amount incurred for the nine months ended September 30, 2003 of $6.7 million. The most significant item included in other expenses is salaries, wages and benefits, which amounted to $4.0 million for the nine months ended September 30, 2004 as compared to $3.9 million for the nine months ended September 30, 2003. The increase of $167,000 or 4% is primarily a result of normal annual raises and higher group insurance costs, offset somewhat by lower bonus accruals in 2004.
Occupancy and furniture, fixtures, and equipment (“FFE”) expenses decreased a total of $11,000 between the first nine months of 2003 and 2004. The decrease was primarily related to an adjustment in property taxes for one of the Company’s branch locations, and lower depreciation due to assets which became fully depreciated in 2003. There were no significant changes in or additions to property and premises between the two comparable periods.
Included in the line item “other expenses”, which decreased $451,000 or 25% from the comparable period of 2003, are charges for OCC assessments; property and bond insurance; ATM switch fees; merchant and credit card expenses; professional services; education and seminars; advertising and public relations; and other branch and customer related expenses. The decrease is primarily related to no FHLB prepayment penalties in 2004 which amounted to $166,000 in 2003 for the early retirement of several advances. Also contributing to the expense reduction was lower advertising ($135,000), consultant fees ($52,000), and other professional fees ($45,000) in 2004 due to changes in the promotional campaigns and other programs of the Company requiring these services. Legal fee s were lower in 2004 by $26,000 related to less loan collection costs in 2004 and the Company realized reductions in merchant credit card expenses of $84,000 due to outsourcing the operations of this product line in mid-2004 and receiving a residual net revenues amount thereafter. Fluctuations in other expense categories are primarily related to deposit related expenses and are a result of normal activity of the Company and normal changes in the volume and nature of transactions.
INCOME TAXES
For the nine months ended September 30, 2004, the Company reported $1.4 million in income tax expense, or an effective tax rate of 30.6%. This is compared to income tax expense of $1.3 million for the same period of the prior year, or an effective tax rate of 31.3%. The slight reduction in effective tax rate is primarily related to the level of tax-free municipal securities in each period.
CAPITAL MANAGEMENT
The Company’s capital serves to support asset growth and provide protection against loss to depositors and creditors. The Company strives to maintain an optimal level of capital, commensurate with its risk profile, on which an attractive return to shareholders will be realized over both the short and long-term, while serving depositors’, creditors’ and regulatory needs. Total shareholders’ equity amounted to $36.2 million, or 11.2% of total assets, at September 30, 2004. This is compared to $32.2 million, or 9.4% of total assets, at December 31, 2003. The $4.0 million increase in total shareholders’ equity resulted principally from retention of earnings and stock issued pursuant to the Company’s stock option plans and restricte d stock plan. Increases in equity were partially offset by cash dividend of $311,000 paid in July 2004. Book value per share at September 30, 2004 and December 31, 2003 was $8.08 and $7.47, respectively.
On December 5, 2003, the Company issued its twelfth consecutive 5% stock dividend to shareholders of record as of November 21, 2003. This dividend resulted in the issuance of approximately 205,000 shares of the Company’s $1.00 par value common stock. Weighted average share and per share data has been restated to reflect all stock dividends issued.
The Company and its bank subsidiary are subject to certain regulatory restrictions on the amount of dividends they are permitted to pay. The Company paid its first annual cash dividend of $0.10 per share in December 2003. In June 2004, the Company declared a semi-annual cash dividend of $0.07 per share payable July 26, 2004 to shareholders of record July 12, 2004. The Company presently intends to pay a semi-annual cash dividend on the common stock; however, future dividends will depend upon the Company’s earnings, financial condition, capital position, and such other factors as the Board may deem relevant. Further, the ability of the Company to pay cash dividends is dependent upon its receiving cash in the form of dividends from the Bank. The dividends that may be pai d by the Bank to the Company are subject to legal limitations and regulatory capital requirements. The approval of the Comptroller of the Currency is required if the total of all dividends declared by a national bank in any calendar year exceeds that bank’s net profits (as defined by the Comptroller) for that year combined with its retained net profits (as defined by the Comptroller) for the two preceding calendar years. It is currently the Bank’s intention to pay all dividends only from the net income of the current year.
To date, the capital needs of the Company have been met through the retention of earnings, from the proceeds of its initial offering of common stock, and from the proceeds of stock issued pursuant to the Company’s stock option plans. The Company believes that the rate of asset growth will not negatively impact the capital base. The Company has no commitments or immediate plans for any significant capital expenditures outside of the normal course of business. The Company’s management does not know of any trends, events or uncertainties that may result in the Company’s capital resources materially increasing or decreasing.
The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. The purpose of these regulations is to quantitatively measure capital against risk-weighted assets, including certain off-balance sheet items. These regulations define the elements of total capital and establish minimum ratios for capital adequacy purposes. To be categorized as “well capitalized”, as defined in the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), Summit Financial and its banking subsidiary must maintain a risk-based Total Capital ratio of at least 10%, a risk-based Tier 1 Capital ratio of at least 6%, and a Tier 1 Leverage ratio of at least 5%, and not be subject to a writ ten agreement, order, or capital directive with any of its regulators. At September 30, 2004, the Company and the Bank exceeded all regulatory required minimum capital ratios, and satisfied the requirements of the well capitalized category established by FDICIA.There are no current conditions or events that management believes would change the Company’s or the Bank’s category.The following table summarizes capital ratios for the Company and the Bank at September 30, 2004 and December 31, 2003.
RISK-BASED CAPITAL CALCULATION
| | | | | | | FOR CAPITAL | | TO BE CATEGORIZED | |
| | | ACTUAL | | ADEQUACY PURPOSES | | “WELL-CAPITALIZED” | |
| | | Amount | | | Ratio | | | Amount | | | Ratio | | | Amount | | | Ratio | |
| | | | | | | | | | | | | | | | | | | | |
As of September 30, 2004 | | | | | | | | | | | | | | | | | | | |
| THE COMPANY | | | | | | | | | | | | | | | | | | | |
| Total capital to risk-weighted assets | | $ | 39,060 | | | 15.59 | % | $ | 20,049 | | | 8.00 | % | | N.A. | | | | |
| Tier 1 capital to risk-weighted assets | | $ | 35,923 | | | 14.33 | % | $ | 10,024 | | | 4.00 | % | | N.A. | | | | |
| Tier 1 capital to average assets | | $ | 35,923 | | | 10.93 | % | $ | 13,152 | | | 4.00 | % | | N.A. | | | | |
| | | | | | | | | | | | | | | | | | | | |
| THE BANK | | | | | | | | | | | | | | | | | | | |
| Total capital to risk-weighted assets | | $ | 33,231 | | | 13.42 | % | $ | 19,817 | | | 8.00 | % | $ | 24,771 | | | 10.00 | % |
| Tier 1 capital to risk-weighted assets | | $ | 30,132 | | | 12.16 | % | $ | 9,908 | | | 4.00 | % | $ | 14,863 | | | 6.00 | % |
| Tier 1 capital to average assets | | $ | 30,132 | | | 9.25 | % | $ | 13,032 | | | 4.00 | % | $ | 16,290 | | | 5.00 | % |
| | | | | | | | | | | | | | | | | | | | |
As of December 31, 2003 | | | | | | | | | | | | | | | | | | | |
| THE COMPANY | | | | | | | | | | | | | | | | | | | |
| Total capital to risk-weighted assets | | $ | 35,223 | | | 13.75 | % | $ | 20,486 | | | 8.00 | % | | N.A. | | | | |
| Tier 1 capital to risk-weighted assets | | $ | 32,019 | | | 12.50 | % | $ | 10,243 | | | 4.00 | % | | N.A. | | | | |
| Tier 1 capital to average assets | | $ | 32,019 | | | 9.92 | % | $ | 12,911 | | | 4.00 | % | | N.A. | | | | |
| | | | | | | | | | | | | | | | | | | | |
| THE BANK | | | | | | | | | | | | | | | | | | | |
| Total capital to risk-weighted assets | | $ | 30,522 | | | 12.05 | % | $ | 20,269 | | | 8.00 | % | $ | 25,336 | | | 10.00 | % |
| Tier 1 capital to risk-weighted assets | | $ | 27,354 | | | 10.80 | % | $ | 10,134 | | | 4.00 | % | $ | 15,202 | | | 6.00 | % |
| Tier 1 capital to average assets | | $ | 27,354 | | | 8.57 | % | $ | 12,772 | | | 4.00 | % | $ | 15,965 | | | 5.00 | % |
LIQUIDITY
Liquidity risk is defined as the risk of loss arising from the Company’s inability to meet known near-term and projected long-term funding commitments and cash flow requirements. The objective of liquidity risk management is to ensure the ability of the Company to meet its financial obligations. These obligations are the payment of deposits on demand or at their contractual maturity; the repayment of borrowings as they mature; the payment of lease obligations as they become due; the ability to fund new and existing loan and other commitments; the payment of operating expenses; and the ability to take advantage of new business opportunities. Liquidity is measured and monitored frequently at both the parent company and the Bank levels, allowing managemen t to better understand and react to balance sheet trends. A comprehensive liquidity analysis provides a summary of anticipated changes in loans, core deposits, and wholesale funds. Management also maintains a detailed liquidity contingency plan designed to respond to an overall decline in the condition of the banking industry or a problem specific to the Company.
Liquidity is achieved by the maintenance of assets which can easily be converted to cash; a strong base of core customer deposits; maturing short-term assets; the ability to sell marketable securities; and access to borrowed funds and capital markets. Historically,deposits have been the primary source of funds for lending and investing activities. The amortization and scheduled payment of loans and mortgage-backed securities and maturities of investment securities provide a stable source of funds, while deposit fluctuations and loan prepayments are significantly influenced by the interest rate environment and other market conditions and competitive factors. Management meets frequently and makes changes relative to the mix, maturity and pricing of assets and liabilities in order to minimize the impact on earnings from such external conditions. Deposits are attractive sources of liquidity because of their stability and generally lower cost than other funding.
In addition to deposits and normal cash flows, FHLB advances and short-term borrowings (including purchasing federal funds from other financial institutions or lines of credit through the Federal Reserve Bank) provide liquidity sources based on specific needs or if management determines that these are the best sources of funds to meet current requirements. At September 30, 2004, based on its approved line of credit equal to 25% of total assets and limited to eligible collateral available, the Bank had additional available credit of approximately $2.4 million from the FHLB. Further, the Bank had short-term lines of credit to purchase unsecured federal funds from unrelated correspondent banks with available balances of $23.1 million at September 30, 2004. The Bank considers advances from the FHLB to be a reliable and readily available source of funds for both liquidity purposes and asset-liability management and interest rate risk management strategies.
Liquid assets, consisting primarily of cash and due from banks, interest-bearing deposits at banks, federal funds sold, and unpledged investment securities available for sale, accounted for 16% and 18%, respectively, of average assets for each of the nine month period ended September 30, 2004 and 2003. Investment securities are an important tool to the Company’s liquidity management. Securities classified as available for sale may be sold in response to changes in interest rates, liquidity needs, and/or significant prepayment risk. In management’s opinion, the Company maintains adequate levels of liquidity by retaining sufficient liquid assets and assets which can be easily converted into cash and by maintaining access to various sources of funds.
As of September 30, 2004, there was no substantial change from the future contractual obligations as of December 31, 2003 as presented in the Company’s 2003 Annual Report on Form 10-K. The foregoing disclosures related to the liquidity of the Company should be read in conjunction with the Company’s audited consolidated financial statements, related notes and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2003 included in the Company’s 2003 Annual Report on Form 10-K.
Summit Financial, the parent holding company, has limited liquidity needs required to pay operating expenses and to provide funding to its consumer finance subsidiary, Freedom Finance. Summit Financial has approximately $2.7 million in available liquidity remaining from its initial public offering and the retention of earnings. In addition, a total of $2.2 million of Summit Financial’s funds were advanced to the Finance Company, in the form of an intercompany loan, to fund its operations as of September 30, 2004. This amount could be replaced by a loan from an unrelated source to create additional liquidity for Summit Financial. Other sources of liquidity for Summit Financial include borrowing funds from unrelated correspondent banks, borrowing from in dividuals, and receipt of management fees and debt service from the Company’s subsidiary on a monthly basis.
Liquidity needs of Freedom Finance, primarily for the funding of loan originations, paying operating expenses, and servicing debt, have been met to date through the initial capital investment of $500,000 made by Summit Financial, retention of earnings, intercompany loan facilities provided by Summit Financial and Summit National Bank, and borrowings from unrelated private investors as necessary. The Company’s management believes its liquidity sources are adequate to meet its operating needs.
OFF-BALANCE SHEET ARRANGEMENTS
The Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the liquidity, credit enhancement, and financing needs of its customers. These financial instruments include legally binding commitments to extend credit and standby letters of credit and involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. Credit risk is the principal risk associated with these instruments. The contractual amounts of these instruments represent the amount of credit risk should the instruments be fully drawn upon and the customer defaults.
To control the credit risk associated with entering into commitments and issuing letters of credit, the Company uses the same credit quality, collateral policies, and monitoring controls in making commitments and letters of credit as it does with its lending activities. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation.
Legally binding commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit obligate the Company to meet certain financial obligations of its customers, if, under the contractual terms of the agreement, the customers are unable to do so. The financial standby letters of credit issued by the Company are irrevocable. Payment is only guaranteed under these letters of credit upon the borrower& #146;s failure to perform its obligations to the beneficiary. As such, there are no “stand-ready obligations” in any of the letters of credit issued by the Company and the contingent obligations are accounted for in accordance with SFAS 5,“Accounting for Contingencies”. At September 30, 2004 and 2003, the Company has recorded no liability for the current carrying amount of the obligation to perform as a guarantor, as such amounts are not considered material.
At September 30, the Company’s total contractual amounts of commitments and letters of credit are as follows:
(dollars in thousands) | | | 2004 | | | 2003 | |
Legally binding commitments to extend credit: | | | | | | | |
| Commercial and industrial | | $ | 12,377 | | $ | 12,477 | |
| Commercial real estate | | | 5,993 | | | 3,011 | |
| Residential real estate, including prime equity lines | | | 19,372 | | | 17,851 | |
| Construction and development | | | 17,348 | | | 18,547 | |
| Consumer and overdraft protection | | | 2,337 | | | 2,510 | |
| | | 57,427 | | | 54,396 | |
| Standby letters of credit | | | 3,687 | | | 3,713 | |
| Total commitments | | $ | 61,114 | | $ | 58,109 | |
EFFECT OF INFLATION AND CHANGING PRICES
The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America which require the measurement of financial position and results of operations in terms of historical dollars, without consideration of changes in the relative purchasing power over time due to inflation. Unlike most industries, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant effect in the financial institution’s performance than does the effect of inflation.
The yield on a majority of the Company’s earning assets adjusts simultaneously with changes in the short-term rates established by the Federal Reserve Board of Governors, specifically the discount rate, changes in which leads to a change in the prime lending rate. Given the Company’s asset-sensitive balance sheet position, assets reprice faster than liabilities, which generally results in decreases in net interest income during periods of declining interest rates. This may cause a decrease in the net interest margin until the fixed rate deposits mature and are repriced at lower current market rates, thus narrowing the difference between what the Company earns on its assets and what it pays on its liabilities. The opposite effect (that is, an increase in net inter est income) is generally realized in a rising rate environment. The degree of interest rate sensitivity of the Company’s assets and liabilities and the differences in timing of repricing assets and liabilities provides an indication of the extent to which the Company’s net interest income may be affected by interest rate movements.
MARKET RISK AND ASSET-LIABILITY MANAGEMENT
The Company’s primary earnings source is its net interest income; therefore, the Company devotes significant time and has invested in resources to assist in the management of market risk. The Company’s net interest income is affected by changes in market interest rates, and by the level and composition of earning assets and interest-bearing liabilities. The Company’s objectives in its asset-liability management are to utilize its capital effectively, to provide adequate liquidity and enhance net interest income, without taking undue risks or subjecting the Company unduly to interest rate fluctuations. The Company takes a coordinated approach to the management of its capital, liquidity, and interest rate risk.
Market risk is the risk of loss from adverse changes in market prices and rates. The Company’s market risk arises principally from interest rate risk inherent in its lending, investment, deposit, and borrowing activities. Management actively monitors and manages its interest rate risk exposure. Other types of market risks, such as foreign currency exchange rate risk, and equity and commodity price risk, do not arise in the normal course of the Company’s business.
Interest rate risk is the exposure to changes in market interest rates. The major source of the Company’s interest rate risk is the difference in the maturity and repricing characteristics between core banking assets and liabilities — loans and deposits. This difference, or mismatch, poses a risk to net interest income. The Company attempts to control the mix and maturities of assets and liabilities to maintain a reasonable balance between exposure to interest rate fluctuations and earnings and to achieve consistent growth in net interest income, while maintaining adequate liquidity and capital. A sudden and substantial increase or decrease in interest rates may adversely impact the Company’s earnings to the extent that the interest rates on earning assets and interest-bearing liabilities do not change at the same speed, to the same extent, or on the same basis.
The Company monitors the interest rate sensitivity of its balance sheet position and controls this risk by identifying and quantifying exposures in its near-term sensitivity through the use of simulation and valuation models, as well as its long-term gap position, reflecting the known or assumed maturity, repricing, and other cash flow characteristics of assets and liabilities. The Company’s simulation analysis involves dynamically modeling interest income and expense from current assets and liabilities over a specified time period under various interest rate scenarios and balance sheet structures, primarily to measure the sensitivity of net interest income over relatively short (e.g., less than 2-year) time horizons. As the future path of interest rat es cannot be known in advance, management uses simulation analysis to project earnings under various interest rate scenarios including reasonable or “most likely”, as well as deliberately extreme and perhaps unlikely, scenarios. Key assumptions in these simulation analyses relate to the behavior of interest rates and spreads, changes in the mix and volume of assets and liabilities, repricing and/or runoff of deposits, and, most importantly, the relative sensitivity of the Company’s assets and liabilities to changes in market interest rates. This relative sensitivity is important to consider as the Company’s core deposit base has not been subject to the same degree of interest rate sensitivity as its assets, the majority of which are based on external indices and change in concert with market interest rates. According to the model, the Company is presently positioned so that net interest income will increase in the short-term if interest rates rise and will decrease in the short-term if in terest rates decline.
A traditional gap analysis is also prepared based on the maturity and repricing characteristics of earning assets and interest-bearing liabilities for selected time bands. The mismatch between repricings or maturities within a time band is commonly referred to as the “gap” for that period. A positive gap (asset sensitive) where interest rate sensitive assets exceed interest rate sensitive liabilities generally will result in the net interest margin increasing in a rising rate environment and decreasing in a falling rate environment. A negative gap (liability sensitive) will generally have the opposite result on net interest income. However, the traditional gap analysis does not assess the relative sensitivity of assets and liabilities to changes i n interest rates and other factors that could have an impact on interest rate sensitivity or net interest income, and is thus not, in management’s opinion, a true indicator of the Company’s interest rate sensitivity position.
The Company’s balance sheet structure is primarily short-term in nature with a substantial portion of assets and liabilities maturing within one year. The Company’s gap analysis indicates an asset-sensitive position over the entire lives of the assets and liabilities. For a 12 month period, the gap analysis indicates an asset-sensitive position as of September 30, 2004 of $14.9 million. When the “effective change ratio” (the historical relative movement of each asset’s and liability’s rates in relation to a 100 basis point change in the prime rate) is applied to the interest gap position, the Company actually has a somewhat higher asset-sensitive gap over a 12 month period. This is primarily due to the fact that in excess of 70 % of the loan portfolio moves immediately on a one-to-one ratio with a change in the prime lending rate, while the deposit rates do not increase or decrease as much or as quickly relative to a prime rate movement. The Company’s asset sensitive position means that assets reprice faster than the liabilities, which causes a decrease in the short-term in the net interest income and net interest margin in periods of declining rates until the fixed rate deposits mature and are repriced at then lower current market rates, thus narrowing the difference between what the Company earns on its assets and what it pays on its liabilities. Given the Company’s current balance sheet structure, the opposite effect (that is, an increase in net interest income and net interest margin) is realized in the short-term in a rising rate environment.
The Company monitors and considers methods of managing the rate sensitivity and repricing characteristics of the balance sheet components in order to minimize the impact of sudden and sustained changes in interest rates. Accordingly, the Company also performs a valuation analysis involving projecting future cash flows from current assets and liabilities to determine the Economic Value of Equity (“EVE”) which is the estimated net present value of those discounted cash flows. EVE represents the market value of equity and is equal to the market value of assets minus the market value of liabilities, with adjustments made for certain off-balance sheet items, over a range of assumed changes in market interest rates. The sensitivity of EVE to changes in the level of interest rates is a measure of the sensitivity of long-term earnings to changes in interest rates, and is used primarily to measure the exposure of earnings and equity to changes in interest rates over a relatively long (e.g., greater than 2 years) time horizon.
The Company’s market risk exposure is measured using interest rate sensitivity analysis by computing estimated changes in EVE in the event of a range of assumed changes in market interest rates. This analysis assesses the risk of loss in market risk sensitive instruments in the event of a sudden and sustained 100 - 300 basis points increase or decrease in the market interest rates. The Company’s Board of Directors has adopted an interest rate risk policy which establishes maximum allowable decreases in EVE in the event of a sudden and sustained increase or decrease in market interest rates.
At December 31, 2003, the Company’s estimated changes in EVE were within the limits established by the Board.As of September 30, 2004, there was no substantial change from the interest rate sensitivity analysis or the market value of portfolio equity for various changes in interest rates calculated as of December 31, 2003. The foregoing disclosures related to the market risk of the Company should be read in conjunction with the Company’s audited consolidated financial statements, related notes and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2003 included in the Company’s 2003 Annua l Report on Form 10-K.
ACCOUNTING, REPORTING AND REGULATORY MATTERS
In January 2003, the FASB issued Interpretation No. 46,“Consolidation of Variable Interest Entities”(“FIN 46”), which addresses consolidation by business enterprises of variable interest entities. A revised version of FIN 46 was issued in December 2003. Under FIN 46, an enterprise that holds significant variable interest in a variable interest entity but is not the primary beneficiary is required to disclose the nature, purpose, size, and activities of the variable interest entity, its exposure to loss as a result of the variable interest holder’s involvement with the enti ty, and the nature of its involvement with the entity and date when the involvement began. The primary beneficiary of a variable interest entity is required to disclose the nature, purpose, size, and activities of the variable interest entity, the carrying amount and classification of consolidated assets that are collateral for the variable interest entity’s obligations, and any lack of recourse by creditors (or beneficial interest holders) of a consolidated variable interest entity to the general credit of the primary beneficiary. The December 2003 revisions to FIN 46 clarify some requirements, addressed identification of variable interest entities, and add new scope exceptions. FIN 46 is effective for all entities that are not “special-purpose” (as defined) entities for the first fiscal year or interim period beginning after December 15, 2003. The unmodified provisions on FIN 46 must be applied to entities that are considered “special-purpose” entities by the end of the first repor ting period ending after December 15, 2003. The adoption of FIN 46 did not have an impact on the Company.
In March 2004, the FASB ratified the consensus reached by the Emerging Issues Task Force (“EITF”) on paragraphs 6 through 20, 22 and 23 of EITF Issue No. 03-01, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments” (“EITF 03-01”). EITF 03-01 provided for adoption of the related consensus as of the beginning of the third quarter of 2004. Subsequent to the FASB’s ratification, in September 2004 the FASB issued FASB Staff Position (“FSP”) EITF 03-1-1 which effectively delay s the guidance in paragraphs 10 through 20 of EITF 03-01 until the FASB issues final guidance, expected in the fourth quarter of 2004. In addition, the FASB issued proposed FSP EITF 03-1-a, which provides guidance on the application of EITF 03-01 to debt securities that are impaired as a result of interest rate and/or sector spread increases, and is expected to be discussed and issued in final form in the fourth quarter of 2004.
Paragraphs 10 through 20 of EITF 03-01 provide guidance on when impairment of debt and equity securities is considered other-than-temporary. This guidance generally states impairment is considered other-than-temporary unless the holder of the security has both the intent and the ability to hold the security until the fair value recovers and evidence supporting the recovery outweighs evidence to the contrary. We are currently evaluating the impact that implementation of this guidance could have on our consolidated financial position or results of operations.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See “Market Risk and Asset-Liability Management” in Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations for quantitative and qualitative disclosures about market risk, which information is incorporated herein by reference.
(a) Evaluation of Disclosure Controls and Procedures
The Company’s principal executive officer and principal financial officer have evaluated the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended, (“the Exchange Act”) as of the end of the period covered by this report. Based upon this evaluation, the principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures are designed and effective to provide reasonable assurance that information required to be disclosed by the Company in the reports filed or submitted by it under the Exchange Act is recorded, processed, summarized and reported within the time periods spec ified in the Securities and Exchange Commission’s rules and forms, and to provide reasonable assurance that information required to be disclosed by the Company in such reports is accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.
(b) Changes in Internal Controls
There was no significant change in the Company’s “internal control over financial reporting” (as such term is defined in Rule 13a-15(f) under the Exchange Act) that occurred during the last calendar quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART II. OTHER INFORMATION
| Item 1. | Legal Proceedings. |
| | The Corporation and its subsidiaries from time to time may be involved as plaintiff or defendant in various legal actions incident to its business. There are no material actions currently pending. |
| | |
| Item 2. | Changes in Securities, Use of Proceeds, and Issuer Purchases of Equity Securitites. |
| | None. |
| | |
| Item 3. | Defaults Upon Senior Securities. |
| | None. |
| | |
| Item 4. | Results of Votes of Security Holders. |
| | None. |
| | |
| Item 5. | Other Information. |
| | None. |
| | |
| Item 6. | Exhibits and Reports on Form 8-K. |
| | |
| (a) | Exhibits: |
| 31.1 -Rule 13a - 14(a) Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes Oxley Act of 2002. |
| | 31.2 - Rule 13a - 14(a) Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes Oxley Act of 2002. |
| 32.1 -Section 1350 Certificate of Chief Executive Officer furnished pursuant to Section 906 of the Sarbanes Oxley Act of 2002. |
| | 32.2 - Section 1350 Certificate of Chief Financial Officer furnished pursuant to Section 906 of the Sarbanes Oxley Act of 2002. |
| | |
| (b) | Reports on Form 8-K: |
| | On October 20, 2004, the Company filed a Form 8-K related to the earnings press release dated October 19, 2004, which included selected financial data for the three month and nine month periods ended September 30, 2004 and for other selected periods. |
SUMMIT FINANCIAL CORPORATION
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
SUMMIT FINANCIAL CORPORATION
| Date: November 1, 2004 | |
| | J. Randolph Potter, President and Chief Executive Officer |
| Date: November 1, 2004 | |
| | Blaise B. Bettendorf, Senior Vice President and Chief Financial Officer |
